Claim Holder in One Class May Purchase Claims in Another Class to Block Cram-Down Plan Confirmation

July 19, 2018

By: Alan Kolod and Richard J. Corbi

The Ninth Circuit Court of Appeals in In re Fagerldala USA-Lompoc, Inc.,1 has provided additional guidance on the question of when the acquisition of claims for the purpose of blocking a reorganization plan is proper. That decision holds that the offer to purchase fewer than all unsecured claims by a secured creditor in order to prevent acceptance of a plan by the unsecured creditor class is not per se evidence of bad faith permitting designation of the resulting “no” votes. The Ninth Circuit employed a concept of bad faith that permits a creditor to acquire claims in a class for the purpose of voting them against the interests of other holders in that class, so long as the creditor was motivated to protect its recovery as a creditor in some other class. On this view, bad faith would be limited to situations where a claim holder votes to obtain an advantage unrelated to its recovery on its claims, such as the classic examples of accepting payment to vote for or against a plan or voting a claim to benefit oneself as a competitor of the debtor.

Fagerdala USA – Lompoc, Inc. (the “Debtor”) commenced a chapter 11 proceeding to prevent foreclosure on real estate worth $6 million. Pacific Western Bank (“Pacific”) held a senior secured claim allowed at about $3.95 million on the Debtor’s real property. The Debtor’s reorganization plan placed Pacific’s secured claim in class 1 and the general unsecured claims in class 4. These were the only classes impaired under the plan. The plan provided for class 1 to receive a restructured mortgage in the full amount of its claim with a lower interest rate and for class 4 to be paid in full in cash within 60 days after confirmation. In order to confirm the plan over Pacific’s objection, the Debtor needed to have its plan accepted by class 4 pursuant to Bankruptcy Code Section 1129(a)(10). To prevent having the plan crammed down on its class 1 secured claim, Pacific embarked on a limited-budget strategy of purchasing only enough class 4 claims to assure that a majority of the class, by number of claims, voted against the plan. The amount spent on class 4 claims allowed Pacific to purchase about 10% ($13,000) of the total allowed amount of all class 4 claims (the “Purchased Claims”), to obtain a “numerosity” blocking position on the class 4 vote.

Pacific voted its secured claim and the Purchased Claims against the plan, preventing acceptance of the plan by any impaired class. The Debtor moved to designate Pacific to prevent consideration of its votes of the Purchased Claims pursuant to Section 1126(e) of the Bankruptcy Code, alleging that Pacific’s use of the Purchased Claims to reject the plan was not in good faith. During the hearing on designation, the Debtor also amended its plan to classify the Purchased Claims separately as class 1B. The Bankruptcy Court designated Pacific’s vote of the Purchased Claims and confirmed the Debtor’s plan. The District Court affirmed. On appeal to the Court of Appeals, the Debtor conceded that, if the vote designation were improper, the reclassification of Purchased Claims was not appropriate. Thus, the question of proper classification of the Purchased Claims was not addressed by the Court, but the Debtor conceded that its own confirmed plan was based on an improper classification. The issue on appeal was whether the designation of Pacific was an error of law.

Section 1126(e) of the Bankruptcy Code provides that “on request of a party in interest, and after notice and a hearing, the court may designate any entity whose acceptance or rejection of such plan was not in good faith or was not solicited or procured in good faith or in accordance with the provisions of this title.” If a movant is successful, then the votes cast by the designated party are not considered in determining whether a class of claims voted in favor of a plan of reorganization.

The Bankruptcy Court based its decision designating Pacific with respect to the Purchased Claims on the findings: (1) that the offer to purchase general unsecured claims was not made to all holders of general unsecured claims and (2) that Pacific’s purchase of a small subset of general unsecured claims to be voted against the plan would be highly prejudicial to the other general unsecured claim holders. The Bankruptcy Court refused as a matter of law to consider the reasons Pacific gave for limiting its purchases of class 4 claims. Rather, the Bankruptcy Court focused its decision on the negative effect of Pacific’s actions on the other holders of class 4 claims. The Bankruptcy Court found an improper “ulterior motive” because Pacific would have an unfair advantage over class 4 creditors who did not receive a purchase offer and who held 90% of the class 4 claims and would receive no recovery absent plan confirmation. Noting that Pacific’s strategy would not have been objectionable had it made offers to all class 4 creditors, the Bankruptcy Court was troubled by the fact that Pacific had acquired a small number of class 4 claims, at a modest price relative to both the total amount of class 4 claims and the value of its class 1 claim, for the purpose of voting those class 4 claims in a manner intended to benefit its class 1 claim at the expense of the recovery of the remaining holders of class 4 claims which Pacific declined to purchase.

The District Court affirmed the Bankruptcy Court decision, and Pacific appealed to the Ninth Circuit Court of Appeals.  Although the Bankruptcy Court did not expressly so find, it was implicit that its finding of bad faith rested Pacific’s motivation to obtain an advantage to which it was not entitled as a class 1 creditor and that was contrary to the interests of the class 4 claims it was voting; thus, the appeal seems to have fairly raised the question of whether it is bad faith to acquire claims to vote them contrary to the interests of the class of which they are members.

The Ninth Circuit reversed as a matter of law, holding that the Bankruptcy Court and District Court erred in considering only the effect of Pacific’s actions on class 4 creditors and ignoring Pacific’s motivation to protect its own class 1 claim. According to the Court of Appeals, the Bankruptcy Court found bad faith based entirely on the fact that offers to purchase were not made to all class 4 holders and the purchased claims were voted to give Pacific an unfair advantage that was prejudicial to other creditors. The Ninth Circuit found these two considerations, alone or together, insufficient to support a finding of bad faith under Section 1126(e). The Ninth Circuit explained that the concept of “good faith” is not defined in the statute and is recognized by the courts to be fluid and not based on a single factor or a single set of factors. While the test stated by some courts is vague and ambiguous, condemning creditors who seek “to secure some untoward advantage over other creditors for some ulterior purpose,” the case law shows that bad faith is not present where the benefit or advantage sought at the expense of other creditors is pursued in one’s capacity as a creditor. Bad faith exists when a creditor votes to further some interest other than its interests as a creditor and seeks to obtain some benefit from its vote to which it is not entitled as a creditor.

The Ninth Circuit first rejected the Bankruptcy Court’s finding that Pacific acted in bad faith by failing to offer to purchase all class 4 claims. Such an offer might be evidence of good faith, but its absence does not constitute bad faith. The Ninth Circuit explained that the purchase of claims to block plan confirmation is not itself evidence of bad faith, and there was no basis in the Bankruptcy Code to require a creditor seeking to acquire claims to block confirmation to acquire more than the number needed to exercise a veto. Since blocking a plan only requires a numerical majority of the class, not the entire class or two-thirds of the class by value, it was not bad faith to limit claim purchases to the number needed to obtain the blocking position. Engaging in an activity permitted by the Bankruptcy Code and case law, without additional evidence of an improper ulterior motive, cannot be bad faith. Accordingly, the Ninth Circuit held that Pacific’s refusal to offer to purchase all class 4 claims, and decision to purchase only enough claims to give it a “numerosity” veto, was not sufficient evidence of bad faith to warrant designation.

The Ninth Circuit then explained the Bankruptcy Court also erred when it failed to make any finding that Pacific acted with an improper ulterior motivation. The Ninth Circuit noted that there is a “distinction between ‘a creditor’s self-interest as a creditor and a motive which is ulterior to the purpose of protecting a creditor’s interest.’” An improper “ulterior motive “is one “to achieve an outside benefit.” A creditor’s actions are not bad faith solely because they appear selfish to those who do not benefit from the actions. The Ninth Circuit continued to explain that bad faith occurs when a creditor attempts to obtain a benefit to which it is not entitled as a creditor. Such examples of bad faith include purchases of claims by third-parties in litigation with the debtor motivated to derail the litigation, purchases of claims by competitors motivated to destroy the debtor’s business and purchases of claims by insiders motivated to support the debtor’s plan for personal reasons. Purchasing additional claims in any class to affect the vote on a plan in order to protect recovery as a creditor in some other class is not evidence of bad faith. Negative impact on other creditors in another class is not enough to justify vote designation. Because the Bankruptcy Court based its finding of bad faith solely on the harm to other creditors and refused to make any finding on Pacific’s motivations for voting against the plan, the Ninth Circuit reversed the designation of Pacific’s vote and remanded the case for further proceedings.

Takeaway

The Ninth Circuit’s decision provides comfort to creditors and claim purchasers who utilize a strategy of acquiring claims in multiple classes in order to vote them to maximize their aggregate recovery as creditors. That strategy does not appear to run afoul of the test for good faith propounded by the Ninth Circuit, and, therefore, should not result in vote designations in those Circuits that follow this view.